50 Economics Classics: the Big Short

People talk of the greed of bankers, but bankers are also prisoners to intellectual paradigms which, if wrong, can produce catastrophic losses.

Michael Lewis’s the Big Short is about the handful of people who not only pointed out that there was something wrong with the subprime mortgage system, but who actively bet against it.

In the 1980s, a new breed of financial company specialised in housing loans for people with little earnings history or collateral, and who did not qualify for government mortgage guarantees. Often it was a second mortgage they were taking out, and not necessarily to buy a house, but to release the equity in their existing house because they needed the money at a lower interest rate.

This ‘subprime’ market was a response to growing income inequality, and served a social purpose by helping poorer Americans pay less for their debt.

The subprime loan companies were another matter. Thanks to a nascent market in mortgage bonds (which pooled thousands of mortgages into securities which could be bought and sold), lenders could quickly sell on the loans they made. They did not have to think about the likelihood that a borrower could service the loan, since it would no longer be their problem.

Lewis profiles Michael Burry, a one-eyed neurologist who left medicine to set up a Californian hedge fund. Smelling an elaborate Ponzi scheme, Burry hatched the idea to sell mortgage bonds short.

Burry could see that if there was an epidemic of mortgage defaults, the bonds representing them could become worthless, and if that happened the owner of the credit default swap could make a fortune: having paid $200,000 in insurance, for instance, you could make $100 million.

Bizarrely, banks selling mortgage bonds had not done their homework on the quality of the home lending that underpinned them, and were willing to sell Burry this insurance.

They were relying on ratings from Moody’s and Standard & Poor’s, but these ratings did not properly distinguish between the riskiness of one mortgage bond and another. Given that borrowers shifted after two years from teaser rates on their mortgages to higher floating rates, defaults were not just possible, Burry thought, but highly likely.

It was Goldman Sachs who created the security which would become famously identified with the crisis of 2008: the ‘collateralised debt obligation’ (CDO). Just as mortgage bonds pooled mortgages, CDOs pooled mortgage bonds.

The idea behind them was that risk was further spread and minimised, but they actually represented a bonanza for banks selling them: triple-B rated mortgage bonds could now become a triple-A rated CDO. It was a brilliant piece of financial engineering built on a lie: if the housing market soured, the structure of subprime loans ensured that defaults would come not in a trickle, but a tidal wave.

House prices began to fall in 2006, and defaults began to increase. The bonds started falling in value, many dropping 30%. Between 2005 and 2007, Wall Street had created in the vicinity of $240-300 billion worth of subprime-backed CDOs, which were now mostly worthless. Bear Stearns and Lehman Brothers collapsed – other banks would have followed if not for government bailouts and guarantees.

When Burry had bought his credit default swaps, they were worth 2% of the value of the CDOs he was betting against. In the end, Wall Street banks paid him 75-85%. In a fund with a portfolio of $550 million, he would add $720 million in pure profit.

Final comments

Where was government in all this? Lewis tells how the Securities and Exchange Commission, the regulator meant to police Wall Street, barely understood the exotic derivatives (such as CDOs) that had vastly increased risk in the financial system, and so was in no position to do its job.

Meanwhile, the ratings agencies were chasing ratings fees and lived in the pocket of the Wall Street bond market.

Secretary of the Treasury Hank Paulson persuaded Congress to supply $700 billion to buy the distressed subprime mortgage assets of banks. By 2009, ‘the risks and losses associated with more than a trillion dollars’ worth of bad investments were transferred from big Wall Street firms to the US taxpayer,’ Lewis writes.

While very few bankers lost their jobs and none went to jail, subprime borrowers were left to default and live in tent cities and gymnasiums while they rebuilt their lives.

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